Business Analysis & Valuation

Business Analysis

& Valuation

Using Financial Statements

Lecture Notes

Professor David M. Chen

Graduate Institute of Finance

Palepu, Krishna G., Paul M. Healy, and Victor L. Bernard 3rd edn, South-Western, Thomson, 2004

Content

I. Framework II. Tools

2. Strategy Analysis

3 & 4. Overview of & Implementing Accounting Analysis 5. Financial Analysis

6. Prospective Analysis: Forecasting

7 & 8. Prospective Analysis: Valuation Theory & Concepts / Implementation

III. Applications

9. Equity Security Analysis

10. Credit Analysis and Stress Prediction 11. Merger & Acquisitions

12. Corporate Financing Policies

13. Communication & Corporate Governance

5 Minutes to Accounting Balance Sheet

Sources of fund:

Owed or borrowed Trade credits

Short-term borrowing Long-term borrowing Invested

Common stock Paid-in capital Preferred stock Earned

Retained earnings Adjustments

Storage of fund:

Current

Cash & equivalents Marketable securities Receivables

Inventory

Prepaid items

Long-term investments Land, plant & equipments Others

Intangibles Goodwill

Income Statement Statement of Cash Flows

Revenue

- Cost of good sold Gross profit

- S&A expenses Operating profit +- Non-operating G/L EBT

- Income taxes Net income

Net income

+ Non-cash expenses - Non-cash revenue + Net interest expenses Operating cash flow +- Working capital +-  Long-term assets +-  Debt financing &

interest expenses +-  Equity financing &

dividend payouts  Cash

Major Accounting Issues

Off-balance-sheet liabilities

Off-balance-sheet financing

Derivatives (financial guarantees)

Financing vs. sales

Purchases vs. leases

Concealed liabilities

Contingent liabilities

Environmental

Employee relationships

Pending lawsuits

Distorted earnings

Timing of revenue recognition

Period-closing sales

Timing of expense recognition

Taking a big bath

Dirty surplus

Asset recognition and measurement

Methods of measurement

Fair value vs. historical cost (impairment)

Depreciation and amortization

Intangible assets

Phantom assets

Fraud

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II. Framework

Questions Addressed

Security analysis

Actual vs. expected performance?

• Analyst own & consensus forecasts?

• Why different?

Valuation given assessment of current & future performance?

Credit analysis

Credit risk involved in lending (trades)?

• Management of liquidity & solvency?

• Business risk & financial risk?

• Loan pricing?

Management consulting

Industry structure?

Strategies pursued by various players?

• Relative performance of different firms?

Corporate management

Fair market valuation?

• Investor communication program adequate?

Search for a potential takeover target

• Value could be added by M&A?

• M&A financing?

Auditing

Accounting policies & accrual estimates consistent with the business &

its recent performance?

• Financial reports communicate current status & significant risks of the business*?

Role of Financial Reporting

Channeling savings into business investments

Socialist (communist) model

• Through central planning and government agencies to pool

national savings and to direct investments in business enterprises (GOEs).

• Delegation of both the political power and the economic power to central planners.

Capitalist model

• The Future of Capitalism*

• Capital markets: shareholder vs. capitalist capitalism (McKinsey).

Recreate credible “inside information”

The functioning of capital markets

Information asymmetry & incentive compatibility problems

• Cost and credibility of communication.

• Lemon markets: unable to differentiate, bad proposals crowed out good proposals, and investors lose confidence in the market.

Financial & information intermediaries

• FSs for laymen vs. for experts?

• The level of financial supervision.*

Savings

Business Ideas

Information Intermediaries Financial

Intermediaries

Ascendancy of Shareholder Value

 Major influencing factors

1. Emergence of an active market for corporate control (LBOs) in the 1980s

 Many mature, established industries that have been subject to hostile takeovers generate high levels of free cash flow.

 Money is invested in businesses that the

company knows, but are not attractive, or in businesses that the company is unlikely to succeed in (diversification).

LBOs substitute equity with debt, forcing much of the free cash flow back into the capital markets in the form of interest and principle payments.

This can also be accomplished voluntarily through a leveraged recapitalization, where a company takes on debt and uses the proceeds to repurchase a large

proportion of its own equity.

The basic premise of the market for corporate control is that managers have the right to manage the corporation as long as its market value cannot be significantly

enhanced by an alternative group of managers with an alternative strategy.

2. Growing importance of equity-based features in the pay package of most senior executives^.

 Perceived divergence between managers’ and shareholders’ interest.

• Anxiousness over 10 years of falling corporate profitability and stagnant share prices.

• The increasing attention paid to stakeholder arguments, which, in the eyes of shareholder value proponents, had become an excuse for inadequate performance.

• Agency theory called for redesigning management’s

incentives to be more closely aligned with the interests of the shareholders.

• By 1998, the estimated PV of stock options represented 45% of the median pay package of CEOs.

• A movement developed to require that nonexecutive board members have an equity stack in the companies they

represented so that they would be more inclined to pay attention to shareholder returns, if only for self-interest.

• By the late 1990s, 48% of medium and large companies had a stock grant or option package for board members, in contrast to virtually none in 1983.

The widening use of stock options has greatly

increased the importance of shareholder returns in the measurement of managerial performance.*

3. Increased penetration of equity holdings as a percentage of household assets.

 Growing segments of the population are becoming shareholders through mutual funds and retirement programs.

 Among the most vocal proponents of shareholder value are the managers of major retirement systems.

 Privatization of large government monopolies where governments became active marketers of the share of these companies.

 The old notions of labor vs. capital are losing currency.

4. Growing recognition that many social systems are heading for insolvency.

 Most of the public pension plans are set up as pay-as-you-go systems: contributions of workers today are used to pay the retirement of current retirees, however, the number of workers to support one retiree is decreasing.*

 Have to move to some form of funded pension system where at least a part of the premiums that workers pay are actually set aside for their retirement.

 The challenge is how to make it through the transition: no solution unless the savings in the funded part (raising

retirement premiums) of the system generate attractive returns.

Shareholder Capitalism

The U.S. corporate focus on shareholder value tends to limit investment in outdated strategies, even encourage

divestment, well before any competing governance model would.

It is hard to claim that the capital markets are shortsighted compared with other corporate governors—the high number and value of technology and internet companies going

public in recent years attests to this.

McKinsey Global Institute attributed the U.S. advantage in GDP per capita to much higher factor productivity,

especially capital productivity (financial returns).*

Virtuous cycle: the most productive and innovative

companies would create the highest returns to shareholders and attract better workers, who would be more productive and increase returns further (Adam Smith).

An economy’s ability to create jobs, or its lack thereof, is the better measure of fairness.

A company that focuses on building shareholder value is served well by being a good corporate citizen: does not come at the expense of other stakeholders.

Market economy: market value added is positively related to labor productivity as well as employment growth.

Business Environment Business Strategy

Business Activities

Accounting Environment Accounting Strategy

Accounting System

Financial Statements

Summarize the economic consequences of business activities

Financial Accounting

From Business Environment to Financial Statements

Business environment

Acquire physical and financial resources.

Create value for investors.

• Labor markets, product markets (suppliers, customers, competitors), capital markets (shareholders, creditors), regulations.

Business strategy

Earns a ROI in excess of the cost of capital

• Scope of business (degree and type diversification), competitive positioning (cost leadership or differentiation), key success factors and risks.

Business activities

Implementing business strategy

• Investment, operating and financing activities*

Accounting system

A mechanism through which business activities are selected (recognized), measured, and aggregated (presentation and disclosure) into FSs.

• Business activities are too numerous to be reported individually, some are proprietary.*

Accounting environment

Institutional features of accounting systems.

• Capital market structure, contracting and governance, accounting convention and regulation, tax and financial accounting linkage, third party auditing, legal system for accounting disputes.

Accounting strategy

Management discretion

• Choices of accounting policies, estimates, reporting format, supplementary disclosure.

FSs

The influence of the accounting system on the quality of FSs.

Accounting system features

Accrual accounting

Periodic performance reports

• Costs and benefits associated with economic activities vs. actual payment and receipt of cash

• The effects of economic transactions are recorded on the basis of expected not necessarily actual cash receipts and payments.

Accounting standards and auditing

The expectations of future cash flow consequences are subjective and rely on a variety of assumptions.

• The accounting discretion granted to managers is potentially valuable because it allows them to reflect inside information, however, they have incentives to use accounting discretion to distort reported profits by making biased assumptions

(management performance assessments, accounting based contracts).

• Accounting conventions are responses to concerns about

distortion, yet they attempt to limit managers’ optimistic bias by imposing their own pessimistic bias (conservatism, measurability).

• Uniform accounting standards GAAP attempt to reduce managers’

ability to record similar economic transactions in dissimilar ways:

SFAS (FASB), IFRS (IASB).

• Increased uniformity comes at the expense of reduced flexibility for managers to reflect genuine business differences in FSs.

• If accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting results.*

• Third party auditing provide a verification of the integrity of the reported FSs, ensures that managers use accounting rules and convention consistently over time, and their accounting estimates are reasonable.

• May also reduce the quality of financial reporting because it constraints the kind of accounting rules and conventions that evolve over time. Auditors are likely to argue against accounting standards producing numbers that are difficult to audit.

• The threat of lawsuits and resulting penalties have the benefits of improving the accuracy of disclosure.

• However, it might also discourage managers and auditors from supporting accounting proposals requiring risky

forecasts, such as forward-looking disclosures.

Managers’ reporting strategy

Some flexibility

• Accounting alternatives and estimates

• Voluntary disclosures

• Proprietary information

• Manipulate investors’ perceptions

Opportunity and challenge in doing business analysis

• Separate distortion and noise from information

• Gain valuable business insights

From FSs to business analysis

Get at managers’ inside information from public FS data.

About current performance and future prospects

• Successful intermediaries have at least as good an understanding of the industry economies as well as a reasonable good understanding of the firm’s competitive strategy.

• Although outside analysts have an information disadvantage, they are more objective.*

Business strategy analysis

Identify key profit drivers and business risks

• Assess the company’s profit potential at a qualitative level.

• Frame the subsequent accounting and financial analysis, i.e., key accounting policies and sustainable profits.

• Make sound assumptions in forecasting future performance.

Accounting analysis

Evaluate the degree to which a firm’s accounting captures the underlying business reality.

• Undo any accounting distortions

• Improve the reliability of conclusion from financial analysis (GIGO)*

Financial analysis

Evaluate the current and past performance and assess its sustainability.

• Analysis should be systematic and efficient.

• Explore business issues through ratio analysis and cash flow analysis.

Prospective analysis

Forecasting a firm’s future

• FS forecasting and valuation

• Synthesis of the above analyses

• For decision contexts such as securities analysis, credit evaluation, M&As, debt and dividend policies, and corporate communication strategies.

EMH

Why FS analysis?

• Application outside the capital market context.

• Driving force of market efficiency.*

Ch. 2 Strategy Analysis

 Starting point

 Strategic decisions

1. The choice of an industry or a set of industries in which the firm operates.

2. The manner in which the firm intends to compete (competitive position).*

3. The way in which the firm expects to create and exploit synergies across the range of businesses (corporate or group strategy)**

Roles

Probe the economics of a firm at a qualitative level

• Subsequent accounting and financial analysis is grounded in business reality.

Identify profit drivers and key risks.

• Assess the sustainability of current performance

• Make realistic forecasts of future performance

Industry analysis

The profitability of various industries differs systematically and predictably over time.

Industrial organization: influence of industry structure on profitability.

Degree of Actual and Potential Competition

Rivalry among Threat of Threat of

existing firms new entrants substitute products

Industry Structure and Profitability

Industry Profitability

Bargaining Power in Input and Output Markets

Bargaining power Bargaining power of buyers of suppliers

Firm Profitability

EBIT/BV of assets was 8.8% (average of U.S. companies between 1981-97).

• Bakery products was 43% higher, silver ore mining was 23% lower.*

Degree of actual and potential competition

One of the key determinants of price

• Perfect competition: price = marginal cost, no abnormal profits

• Monopoly profits

Rivalry among existing firms

• Industry growth rate: in stagnant industries, the only way existing firms can grow is by taking share away from the other firms.

• Concentration and balance of competitors: the number of firms in an industry and their relative sizes determine the degree of

concentration, which in turn influences the extent to which firms can coordinate their pricing and other moves.*

• Degree of differentiation and switching costs

• Scale/learning economics (learning curve) and the ratio of fixed to variable costs (degree of operating leverage = CM/F)

• Excess capacity and exit barriers*

Threat of new entrants

• Economies of scale: might arise from large investment in R&D, brand advertising, or physical plant & equipment

• First mover advantage: set industry standards, enter into exclusive arrangements with suppliers of cheap new materials, acquire scarce government licenses, achieve learning economies, or impose

significant switching costs.

• Access to channels of distribution (dealer network, supermarket shelf) and relationships

• Legal barriers: patents and copyrights, licensing regulations

Threat of substitute products

• Perform the same function, not necessary of the same form (replacement not reproduction).

• Technologies enable efficiency in (reduced) usage.*

• Image offered by designer labels.

Bargaining power of buyers and suppliers

Price sensitivity

• Product differentiation and switching costs.

• Importance to cost structure.

• Importance to product quality or composition.

Relative bargaining power

• The extent to which firms will succeed in forcing price down: the cost of each party of not doing business with the other party

• Number of buyers relative to number of suppliers, volume of purchase, number of alternative products, switching costs, threat of forward or backward integration.*

Limitations of industry analysis

The assumption that industries have clear boundaries.

Competitive strategy analysis

Cost leadership

Tight cost control

• Economies of scale and scope, economies of learning, efficient production, simpler product design, lower input costs, low

distribution costs, little R&D or brand advertising, and efficient organizational processes.

Differentiation

Provide a product or service that is distinct in some important respect valued by the customer.

• Identify one or more attributes of a product that customers value:

quality, appearance, variety, reputation or brand image, bundled services, delivery time, or turnkey solutions.

• Position itself to meet the chosen customer need in a unique manner.

• Achieve differentiation at a cost that is lower than the price the customer is willing to pay.

• Investments in R&D, engineering skills, and marketing capabilities.

• The organizational structures and control systems need to foster creativity and innovation.

Mutually exclusive

Firms that straddle the two are considered to be “stuck in the middle”

• Not able to attract price conscious customers and unable to provide adequate differentiation to attract premium price customers.

• Firms cannot completely ignore the dimension on which they are not primarily competing: distinctive and high quality yet inexpensive.*

Achieving and sustaining competitive advantage

The capabilities needed to implement and sustain the chosen strategy

• Acquire the core competencies (economic assets) needed and structure value chain (the set of activities performed to convert inputs into outputs) in an appropriate way.**

• Difficult for competitors to imitate.

Questions asked

• Key success factors and risks associated with chosen competitive strategy?

• Having resources and capabilities to deal with?

• Making irreversible commitments to bridge the capabilities gap?

• Structuring activities consistently?

• Creating barriers to imitate?

• Having flexibility to address potential changes in the industry structure that might dissipate competitive advantage?

Corporate strategy analysis (scope)*

Multibusiness organization

• The average number of segments operated by the top 500 U.S.

companies is 11 in 1992.

• An attempt to reduce the diversity and focus on a relatively few core businesses: diversified companies trade at a discount in the stock market relative to a comparable portfolio of focused companies, M&A of two unrelated businesses often fail to create value, and value can be created through spin-offs and asset sales.

• Managers’ decisions to diversify and expand are driven by a desire to maximize the size rather than shareholder value, incentive misalignment problems, and capital markets find it difficult to monitor and value multibusiness organizations.*

• Evaluate the economic consequences of managing all the different businesses under one corporate umbrella.

Sources of value creation

• Relative transaction cost of performing a set of activities inside the firm versus using the market mechanism, in particular, when coordination among independent firms is costly due to market transaction costs.

• Transaction costs: production process involves specialized assets such as human capital skills, proprietary technology, other

organizational know-how that is not easily available in the marketplace, and market imperfection such as information and incentive problem.

• Emerging economies often suffer from market imperfection because of poorly developed intermediation infrastructure.*

• Internal advantages: lower communication costs because

confidentiality can be protected and credibility can be assured

through internal mechanism, headquarters office can play a critical role in reducing costs of enforcing agreements, organizational

subunits can share nontradable or nondivisible assets.

• Top management may lack the specialized information and skills necessary to maintain businesses across several different

industries. Can be remedied by creating a decentralized

organization, hiring specialist managers and providing with proper incentives, but will potentially decrease goal congruence.

Questions asked

• Significant imperfections in the product, labor, or financial markets?

• Special resources such as brand names, proprietary know-how, access to scarce distribution channels, and special organizational processes?

• Good fit between specialized resources and the portfolio of businesses?

• Allocation of decision rights between the headquarters office and business units?

• Internal measurement, information, and incentive system to reduce agency costs?

Cases

Personal computer industry

Intense competition and low profitability

• The industry was fragmented with many firms producing virtually identical products, though top five vendors controlling close to 60%

of the market.

• Component cost accounted for more than 60% of total hardware costs and volume purchases reduced these costs, hence intense competition for market share.

• Brand name and service became less important as buyers became more informed about the technology.

• Switching costs were relatively low.

• Access to distribution was not a significant barrier (direct mail & internet-based sales). Computer superstores were willing to carry several brands.

• Very few barriers to entering the industry (assembled in a dormitory room).

• Apple’s and workstations offered competition as substitutes.

• Key hardware and software components were controlled by firms with virtual monopoly (Intel, Microsoft).

• Corporate buyers were highly price sensitive (a significant IT cost).

• Tremendous pressure on firms to introduce new products rapidly, maintain high quality and provide excellent customer support.

Dell’s low-cost competitive strategy

• Direct selling: saving on retail markups

• Made-to-order manufacturing: a system of flexible manufacturing (5 days), save inventory working capital and write-off costs.

• Third-party service: telephoned-based and third-party maintenance service (Xerox).*

• Low accounts receivable: pay by credit card or electronic payment.

• Focused investment in R&D: primarily in creating low-cost, high velocity organization that can respond quickly to changes.

Electronic commerce

Amazon.com, an online bookseller in 1995 and went public in 1997 with a market cap of $561m and increasing to $36b by April 1999.

• Jeff Bezos moved the company into many other areas, claimed that its brand, loyal customer base, and ability to execute electronic commerce were valuable assets that can be exploited in a number of other online business areas: CDs, videos, gifts, prescription drugs, pet suppliers, and groceries (a “customer” company).

• Traditional retailers such as Barnes & Noble, Wal-Mart, and CVs who are boosting their online efforts also have valuable brand names,

execution capabilities, and customer loyalty.

• Expanding rapidly into so many different areas is likely to confuse customers, dilute brand name, and increase the chance of poor execution.*

Ch. 3 Accounting Analysis

Overview

Purpose

Improve the reliability of conclusions from financial analysis (GIGO)

Evaluate the degree to which a firm’s accounting captures its underlying business reality.

• Identifying places where there is accounting flexibility

• Evaluating the appropriateness of the firm’s accounting policies and estimates

• Consistent with stated strategy

Undo any accounting distortions

• Adjusting a firm’s accounting numbers using cash flow and footnote information

Institutional Framework

Accrual accounting

Recording of costs and benefits associated with economic activities.

• The effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments.

Revenue

• Economic resources earned during a time period

• Governed by the realization principle

• The firm has provided all, or substantially all, the goods or services to be delivered to the customer

• The customer has paid cash or is expected to pay cash with a reasonable degree of certainty

Expenses

• Economic resources used up in a time period

• Governed by the matching and conservatism principles*

• Costs directly associated with revenues recognized in the same period (COGS)

• Costs associated with benefits that are consumed in this time period (period expenses)

• Or, resources whose future benefits are not reasonably certain (R&D, advertising)

• Expenses vs. losses

Assets

• Economic resources owned by a firm

• Likely to produce future economic benefits

• And, measurable with a reasonable degree of certainty*

• Costs: sacrifice foregone to acquire goods or services, initially as assets then as expenses.

Liabilities

• Economic obligation of a firm arising from benefits received in the past

• Required to be met with a reasonable degree of certainty.*

• And, whose timing is reasonably well defined

Equity: net worth (limited liability)

Delegate reporting to management

Involves complex judgments

• Sales with customer financing*

• Potential defaults

• R&D assets or contingent liabilities

• Contractual commitments such as lease arrangements or post-retirement plans

Costs and benefits

• Use their accounting discretion to reflect inside information in reported FSs

• But have an incentive to distort reported profits by making biased assumptions

• Manipulate accounting numbers in contracts between the firm and outsiders

• GAAPs, external auditing, and legal system to reduce the cost and preserve the benefit (only institutional investors’ supervision is effective).

GAAPs

Historical cost convention to reduce value manipulation

• Limits the information that is available to investors about the potential of the assets

• Fair value and impairment

Uniform accounting Standards

• Create a uniform accounting language and increase the credibility of FSs

• Regulate how particular types of transactions are recorded to limit management’s ability to misuse accounting judgment

• Rigid standards work best for economic transactions whose accounting judgment is not predicated on managers’ proprietary information.

At the expense of reduced flexibility to reflect genuine business differences

• Likely to be disfunctional because they prevent managers from using their superior business knowledge.

• May induce managers to expend economic resources to structure business transactions to achieve a desired accounting result.*

SEC has the legal authority to set accounting standards

• Typically relies on private sector accounting bodies to undertake this task

• FASB’s SFAS since 1973

IASB’s IFRS after reform since 1998

External auditing

All listed companies are required

• GAASs set by AICPA

• Issue an opinion on published FSs

• Primary responsibility still rests with corporate managers

Imperfect

• Cannot review all of a firm’s transactions

• Failure because of lapses in quality or lapses in judgment by auditors who fail to challenge management for fear of losing future business.

• Outside supervision replaces peer reviews

• Also under international harmonization because of capital markets integration.

• Constrain the type of accounting rules and conventions that evolve over time

• Auditors are likely to argue against accounting standards that produce numbers which are difficult to audit, even if the proposed rules produce relevant information for

investors.

Legal system

Adjudicate disputes between managers, auditors, and investors

• The threat of lawsuits and resulting penalties have the beneficial effect of improving FSs.

• The potential for significant legal liability might also discourage managers and auditors from supporting accounting proposals requiring risky forecasts.

Quality Factors

Noise and bias from accounting rules

Conservatism: not possible

• Timing of recognition due to double-entry accounting.

• Managerial behavior may not necessarily be consistent with conservatism.

Dissimilar economic events with similar accounting rules, e.g., R&D

Forecast errors

The extent of errors depends on a variety of factors

• The complex of the business transactions

• The predictability of the firm’s environment

• Unforeseen economic-wide changes.

Managers’ accounting choices

Incentives to exercise discretion to achieve certain objectives

• Accounting based debt covenants

• Management compensation

• Corporate control contests: in hostile takeovers and proxy fights, accounting numbers are used extensively in debating managers’

performance.

• Tax considerations

• Regulatory considerations: to influence regulatory outcomes such as antitrust actions, import tariffs, and tax policies.

• Capital market considerations (IPOs, ECBs, may simply due to market timing)

• Stakeholder considerations: labor unions, suppliers, and customers (stockholders, community)

• Competitive considerations: segment disclosure, business concentration (major customers), new entrants.

Level of disclosures

• Managers can choose disclosure policies that make it more or less costly for external users to understand the true economic picture.

• Voluntary disclosures: Letter to the

shareholders, MD&A, footnotes (part of FSs)

 Steps in accounting analysis

1. Identify key accounting policies

 Industry characteristics and competitive strategy

• Key success factors and risks

• Identify and evaluate the accounting policies and estimates the firm uses to measure them

• Evaluate how well they are managed

 Examples

• Banking: interest and credit risk management (loan loss reserves)

• Retail: inventory management

• Manufacturer: product quality and innovation, R&D, product defects after the sale (warranty expenses and reserves)

• Leasing: accurate forecasts of residual values

2. Assess accounting flexibility

 Little flexibility

• Accounting data are likely to be less informative

• R&D of biotechnology companies

• Marketing outlays of consumer goods firms

 Considerable flexibility

• Potential to be informative depending on how managers exercise it

• Expected defaults of bank loans

• The point in the development cycles to capitalize outlay by software developers

 Common flexibility

• Accounting alternatives allowed

3. Evaluate accounting strategy

 Strategy questions asked

• Compare to the norms of the industry

• Dissimilarity because of unique competitive strategies? (e.g., high quality low warranty allowance or understating)

 Strong incentives to use accounting discretion to manage earnings?

 Policies and estimates changed

• Justification & impact

 Realistic in the past

• Seasonality in interim earnings or manipulation

• Large period-ending adjustments

• A history of write-offs

 Structure any significant business transactions to achieve certain accounting objectives?

• Hiding losses in SPEs or joint ventures

4. Evaluate the quality of disclosure

 Questions asked

• Adequate disclosures to assess the firm’s business strategy and its economic consequences (letter to the shareholders)?

• Footnotes adequately explain the key accounting policies and assumptions and their logic?

• Adequately explain current performance (MD&A)?

• If accounting rules and conventions restrict the firm from measuring them appropriately? Adequate additional

disclosure to help understand how key success factors are managed, e.g., disclose physical indexes of defect rates and consumer satisfaction. KPIs

• Quality of segment disclosure

• Forthcoming with respect to bad news: reasons and coping strategy.

• Investor relations program

5. Identify potential red flags

 Examine more closely or gather more information

• Unexplained changes in accounting, especially when performance is poor.

• Unexplained transactions that boost profits.

• Unusual increases in accounts receivables in relation to sales increases: relaxing credit policy or artificially loading up distribution channels

• Unusual increases in inventory in relation to sales increases (FG:

demand slowing down, WIP: expect an increase in sales, RM:

manufacturing or procurement inefficiencies).*

• Increasing gap between reported income and cash flow from operating activities. If not a steady relationship, might indicate subtle changes in the firm’s accrual estimates.*

• Increasing gap between reported income and tax income: might indicate subtle changes in accounting standards or tax rules.

• Large fourth-quarter adjustments: may indicate aggressive management of interim reporting.

• Tendency to use financial mechanisms such as R&D

partnerships, SPEs, and the sale of receivables with recourse:

opportunity to understate liabilities and/or overstate assets.

• Unexpected large write-offs: slow to incorporate changing business circumstances into accounting estimates.

• Qualified audit opinions or changes in independent auditors not well-justified: tendency to opinion shop.

• Related-party transactions: lack the objectivity of the

marketplace and likely to be more subjective and self-serving.

6. Undo accounting distortion

 Some progress can be made by using the cash flow statement and footnotes.

Pitfalls

Common misconceptions

Conservatism is not “good” accounting

• Evaluate how well accounting captures business reality in an unbiased manner.

• Merck’s research ability and sales force.

• Look to alternative sources of information.

• Provide opportunities for income smoothing.

• Prevent analysts from recognizing poor performance in a timely fashion.

Not all unusual accounting is questionable

• Justified if the business is unusual.

• Accounting changes might reflect changed business circumstances.

Value of accounting data and analysis

Accounting data

Perfect earnings foresight one year prior to announcement

• Buy up sell down, 37.5% 1954-1996

• Equivalent to 44% of the return given perfect foresight of the stock price (85.2%)

• Perfect foresight of ROE, 43%

• Perfect foresight of cash flow, 9%

• Earnings management not so pervasive as to make earnings data unreliable.

Accounting analysis

Opportunities for superior analysts to earn positive profit.

• Companies criticized in the financial press for misleading financial reporting suffered an average stock price drop of 8%.

• Firms appeared to inflate reported earnings prior to an equity issue and subsequently reported poor performance had more negative stock performance after the offer than firms with no apparent inflating.*

• Firms subject to SEC investigation for earnings

management showed an average stock price decline of 9%

when first announced and continued to have poor stock price performance for up to two years.

Ch. 4 Implementing Accounting Analysis

Undo any accounting distortions

Recasting FSs using standard reporting nomenclature and formats

Performance metrics based on comparable definitions across companies and over time

• Focus on those accounting estimates and methods used to measure key success factors and risk.

• Assess whether variations reflect legitimate business differences or differential managerial judgment or bias.

• Even if accounting rules are adhered to consistently, distortion can arise because accounting rules themselves do a poor job of capturing firm economics.

• Information taken from footnotes, cash flow statement and other sources may enable a precise adjustment, otherwise make an approximate adjustment.*

Once any asset and liability misstatements have been identified

• Make adjustments to the balance sheet at the beginning and/or end of the current year, as well as needed adjustments to

revenues and expenses in the latest income statement.

• Ensure that the most recent financial ratios used to evaluate a firm’s performance and forecast its future results are based on financial data that appropriately reflect its business economics.

Asset Distortions

Definition of assets

Resources that a firm owns or controls as a result of past business transactions, and which are expected to produce future economic benefits that can be measured with a

reasonable degree of certainty.

Ownership or control

Difficult for accounting rules to capture all of the subtleties associated with ownership.

• Permits managers to groom 打扮 transactions so that essentially similar transactions can be reported in very different ways:

important assets may be omitted from the balance sheet even though the firm bears many of the economic risks of ownership.

• There may be legitimate differences in opinion between

managers and analysts over residual ownership risks borne by the company (recognition and derecognition).

• Aggressive revenue recognition which boost earnings is also likely to affect asset values: recognized only when products have been shipped or services have been provided to the

customer, when the customer has a legal commitment to pay, and when cash collection is reasonable likely. Hence frequently coincides with ownership of a receivable.

Examples

• Leases: bankruptcy of airlines

• Discounting receivables with recourse

• Revenue recognition: transactions with nonconsolidated affiliates or at period’s end.

• Securitization (true sales): nonconsolidated SPEs

Future economic benefits

Measured with reasonable certainty.

• Difficult to accurately forecast the future benefits associated with capital outlays.

• Whether a competitor will offer a new product or service.

• Whether the products manufactured at a new plant will be the type that customers want to buy.

• Whether changes in oil prices will make the oil drilling equipment manufactured less valuable.

Accounting rules deal with these challenges by stipulating which types of resources can be recorded as assets and which cannot.

• Yet, economic benefits should not be a yes or no question, nor should be measured at cost.*

Example: R&D expenses

• Generally considered highly uncertain.

• May never deliver promised products, the products

generated may not be economically viable, or products may be made obsolete by competitors’ research.

• Exception: SFAS 86 requires software development costs be capitalized once the software reaches the stage of

technological feasibility.

Impairments

The possibility that asset values are misstated.

• SFAS 144: an impairment loss (difference between the fair value and book value) be recognized on a long-term asset when its book value exceeds the undiscounted cash flows expected to be generated from future use and sale.

Measurement of impairment is based on discounted cash flows

• Markets for many long-term operating assets are illiquid or incomplete, making it highly subjective to decide whether an asset is impaired and to infer its fair value.

The task of impairment judgment is delegated to management, with oversight by the auditor.

• Potentially leaving opportunities for management bias and for legitimate differences in opinion between managers and

analysts over asset valuations.

• Independent valuation internal as well as external.

Overstated assets

Incentives to increase reported earnings

Delays in writing down current assets

• Impaired if book values fall below realizable values.

• Write-offs are charged directly to earnings.

• Where management of inventories and receivables is a key

success factor, analysts need to be particularly cognizant of this form of earnings management: overstocking (offer customer discounts or credit extension).

• Warning signs: growing days’ inventory, days’ receivable, write- down by competitors, and business downturns for major

customers.

Underestimated reserves

• Allowances for bad debts or loan losses.

• Warning signs: growing days’ receivable, business downturns for major clients, and loan delinquencies.

Accelerated recognition of revenue

• Increasing receivables (at the period’s end while cash collection may not be reasonably likely).

Delayed write-downs of long-term assets

• Deteriorating industry/firm economic conditions.

• Aggressive growth through acquisitions (intangible assets and goodwill impairments).

• Heavy asset-intensive firms in volatile markets.

• Warning signs: declining long-term asset turnover, return on assets lower than the cost of capital, write-downs by other firms, overpayment for or unsuccessful integration of key acquisitions.

Understated depreciation/amortization on long-term assets

• Estimates of asset lives, salvage values, and amortization schedules. 摩爾定律

• Heavy asset businesses: airlines, utilities, and semiconductor foundries.

Case: Dot-com stock market crash in April 2000.

• A ripple effect on firms selling equipment to the

telecommunications and internet industries, e.g., Lucent Technologies.

• First sign of a downturn came in the June 2000 quarter, when earnings declined markedly YoY.

• This pattern persists through the next two quarters with reported operating losses of $2.1b and $4.8b, respectively.

• Reported year-end inventory $6.9b was $1.5b higher YoY, yet fourth quarter sales $5.8b declined precipitously from $9.9b previous year.

• Day’s inventory increase from 58 days to 107 days, gross margins declined from 47% to 22%, yet recorded no inventory impairment charge.

• Can assess the problems by talking to Lucent’s customers and by observing the performance of other firms in the industry.

• Inventory write-down was $536m in March 2001, $143m in June, and $11m in September.

• Accounts receivable allowances increased from 5% in September 2000 to 7% in December.

• Requires a thorough review of the short-term cash generating potential of major customers.

• Reported estimates were 8.7% in March 2001, 11.2% in June, 12.5% in September, and 19.5% in December ( 帳齡分析 ).

Case: MicroStrategy, a software company

• Recognized revenues from the sale of licenses “after execution of a licensing agreement and shipment of the product, provided that no significant Company obligations remain and the

resulting receivable is deemed collectible by management.”

• Booking two contracts (announced several days after the quarter’s end) worth $27m as quarterly revenues.

• Cost of license revenues is only 3% (should be a prepaid expense, no inventory).

• Restate FSs: Accounts receivable were reduced from $61.1m to $37.6m for 1999 (contracts not fully executed by the

Company in the reporting period).

Case: merger between AOL and Time Warner

• Enabling AOL to cross-sell TW’s content to its large

subscriber base, goodwill valued at $128b in December 2001.

• Disney’s acquisition of ABC had faced difficulties in realizing their potential.

• Why AOL had to buy TW to access its content (simply sign a long-term licensing agreement)?

• Raised questions about AOL and TW relations

with existing customers and suppliers: TW sells to AOL’s competitor Microsoft, AOL’s deals with TW’s competitors, and even if TW content

become stale, AOL has no choice but to continue supplying.

• Questions quickly answered when Internet sector stocks crashed.

• Goodwill write-down of $54b in March 2002, additional write-down of $45.5b at the end of 2002.

Understated assets

Incentives to deflate reported earnings

Income smoothing

• Performed exceptional well and decided to store away some of the current strong earnings for a rainy day.

• Overstating period expenses

Take a bath

• In a particular bad year to create the appearance of a turnaround in following years.

Incentives to understate liabilities

• Neither the assets nor the accompanying obligations are shown on the balance sheet.

• Operating lease, discounting receivables with recourse, offset.

Conservative accounting rules

• Expense R&D and advertising outlays

• Pooling of interests

• Under double-entry accounting, conservative is followed by aggressive.

Common forms

• Overstated write-downs of current assets: can also arise when managers are less optimistic about the future prospects.

• Overestimated reserves

• Overestimated write-downs of long-term assets

• Overstated depreciation/amortization: accelerated tax depreciation

• Excluded goodwill using pooling*

• Lease assets off balance sheet: whether the lessee has

effectively accepted most of the risks of ownership, such as obsolescence and physical deterioration

– SFAS 13 require purchase treatment if any of the

following holds: ownership is transferred to the lessee at the end of the lease term; the lessee has the option to purchase for a bargain price at the end of the term; the lease term is 75% or more of the asset’s expected useful life; the present value of the lease payments is 90% or more of the fair value of the asset.

– Opportunities for management to circumvent the spirit of the distinction between capital and operating leases, likely to be an important issue for the heavy asset industries.

• Discounted receivables with recourse: still retains considerable collection risk. *

– SFAS 140 requires to be considered sold if the seller cedes control to the financier beyond the reach of the seller’s

creditors should seller file for bankruptcy; the financier has the right to pledge or sell the receivables; and the seller has no commitment to repurchase.

– If with recourse, requires the seller to continue to estimate bad debt losses. Also requires the seller to have experience in estimating the value of the recourse liability (allowances for credit and refinancing risks).

– Affect both income and liability: gains and losses on the sales to be excluded, interest income on the notes

receivable and interest expenses on the loan to be recorded.

• Key intangible assets not reported: inflates ROE, will not be mean-reverting to the cost of capital. Make it difficult to assess whether the firm’s business model works (against the matching concept and obscures operating performance).

Likely to be important for firms in software, pharmaceutical, branded consumer products, and subscription businesses.*

Case: Lufthansa, German national airline

• In 2001, depreciated aircraft over 12 years on a straight-line basis with estimated residual value of 15% of initial cost, for both financial and tax reporting purposes. British Airways (BA): 20 years & 8% for financial reporting purpose.

• Reflect different fly routes, asset management strategies (newer planes, lower maintenance cost, lower fuel costs, cargos vs. passengers).